Are markets about to shift gear?

Risk assets endured a disastrous start to the year, the worst year since the onset of the Great Depression. If investors had been told to put their monies into Asian and emerging markets back then, most would have baulked at such a suggestion.

However, now well into the final quarter of the year, these markets have been quite comfortably outstripped their developed market counterparts for the year-to-date. 

This path has been echoed by sectors that have also been out of favour in recent years, but recovered strongly in 2016, namely commodities and energy. Some of this can be attributed to the US dollar because there is an inverse relationship between the value of the US dollar and oil and commodity prices.

When the US dollar strengthens, oil and commodity prices generally weaken. What we have seen during the course of this year is that the US dollar has softened. This was mainly because the forecasted, incremental US interest rate rises that were mooted at the beginning of this year never materialised. 

It must be noted that we are still in the midst of a multi-year central bank experiment. Monetary policy has steered the markets and now currency fluctuations are having much more of an effect on markets than ever before. We are currently in a lowly world: low interest rates, low growth and low inflation.

This has led to an ongoing dichotomy between investors. In one camp, we have those focused on long-duration, quality stocks that provide sustainable growth and dividends on a multi-year basis. The consumer staples sector has been used at the vanguard of this approach. This includes stocks such as Unilever and Nestlé. The quality investor is seeking low earnings risk and low dividend risk.

Such has been the demand for these types of stocks, they have become relatively expensive. Investors who favour these relatively safer areas of the market are now having to pay higher prices for them.

However, on the flip side to this is the value investor. They are not prepared to pay for stocks they believe are expensive and prefer to take a contrary stance. They look for stocks that have fallen out of favour or which are being ignored by the broader market. Unfortunately for the value investor, this style of investing has been out of favour for a decade.

The trigger for value and cyclical stocks to start gaining momentum is not a rise in interest rates, although this could well be conducive to a period of outperformance. No, it is more the recent uptick in inflation that we have witnessed, particularly in developed markets. Value investors argue the catalyst for value to recover and for quality stocks to falter is for the market to believe that inflation is coming back.

They argue that the downside risk is limited in that we are in a low inflation and deflationary environment already. They argue that a mere sniff of inflation may be enough to get investors thinking differently.

If we look at the UK market in more detail, this can give us an excellent view of the larger equity picture, particularly within developed markets. For instance, we have an emergency interest rate environment, an investor demand for yield, politically influenced markets and a weak currency. These are all dictating the fortunes for different parts of the UK stock market. 

It seems hard to believe that since the UK’s momentous decision to leave the European Union this summer that UK stock markets would push near to record highs only months ago. While this rally provided some relief given the immediate concerns after the referendum, the outlook for the UK economy remains unclear. Only time will tell what Brexit actually looks like. 

Since the Brexit vote, UK large cap global businesses have been the big winners. Many benefit from sterling’s weakness because these companies generate overseas earnings in US dollars. Additionally, the Bank of England’s recent interest rate cut and gilt purchase programme squeezed deposit rates and bond yields further. This has increased demand for dividend-paying blue chip companies, for which the UK market is traditionally known.

However, when seeking dividends, what route might investors go down? At present, there are lots of FTSE 100 stocks paying attractive dividends, but dividend cover remains a problem. With many large caps facing issues, such as increasing pension deficits and historically low commodity prices, dividend cover is likely to remain problem in the foreseeable future. 

For example, income stalwarts, such as BP and Shell, continue to pay attractive dividends of more than 5 per cent, although dividend coverage is low and the ability to keep paying a dividend in the future with oil prices at suppressed levels is in doubt. 

By contrast, consider Unilever, which is trading on a price-to-earnings ratio of just under 20x and offering a yield of little more than 3 per cent. Quality focused investors would argue this remains an attractive long-term investment given where interest rates and government bonds yields are at the moment. 

The comparison is stark with a company such as Royal Dutch Shell, which is trading on 8.5x and is offering a yield of just under 6 per cent. 

However, the market landscape could be shifting. As we have witnessed across global markets, not just the UK, value is showing the first signs of outperformance. The anticipation of some inflation (albeit small) is being priced in by markets. This is good news for the cheaper, cyclical areas of the market. Time will tell if it is a new era or one of the number of false dawns seen over recent years. 

Ben Willis is head of research at Whitechurch Securities

Key points 

Asian and emerging markets have comfortably outstripped their developed market counterparts for the year-to-date. 

The trigger for value and cyclical stocks to start gaining momentum is most likely to be provided by upticks in inflation.

Since the Brexit vote, UK large cap global businesses have been the big winners. They benefit from sterling weakness because these companies generate overseas earnings in US dollars.